Climate Risk Bonds for Adaptation Finance

Bonding requirements for risky industries are nothing new. Most countries have one form or another. It is time to extend this concept to the unambiguous risks associated with climate change. Here is how it would work.

Before new permits are issued for fossil fuel extraction, countries, states, or local governments (and this depends on the structure of a particular country’s laws) would require posting of a climate risk bond,calculated as the social cost of carbon multiplied by the amount of carbon emissions added to the atmosphere from the entire life cycle of production and final consumption of the oil, gas, and coal produced from a particular well, mine, or offshore platform. Already, most countries require posting of bonds to cover the potential public liabilities associated with oil spills, abandonment of fossil fuel infrastructure, industrial accidents, and natural resource damages. Unfortunately, bond amounts are often trivial in comparison to potential public liabilities.

The same institutional mechanisms in place to collect these bonds could be retooled and extended to cover the costs of carbon emissions – but with one important change. The funds collected would be deposited into a fund managed by an international entity (but with enough retained locally to cover administration) since the costs of climate change manifest at a global level and disproportionately affect low-income countries that have a limited role in extraction. The Green Climate Fund provides a working example. Disbursements would be made from that fund to cover adaptation costs, disaster response and readiness, and reimburse energy companies that transition out of fossil fuels. Eligible countries would be those that produce fossil fuels and choose to participate, and those that do not produce at all. Protocols for eligible disbursements and setting priorities can be adapted from innovate financing mechanisms already being pioneered, such as the World Bank’s catastrophe risk insurance pilot operation.

To get a sense of what this would mean, each year, the carbon dioxide content embodied in the lifetime production of a typical well – take the Bakken field as an example – is roughly 250,000 metric tons. At a social cost set at $40 USD per ton, this would translate into a climate bond of $10,000,000, about half of net profits. When operations cease, the money is returned with interest after deducting proportional disbursements for climate adaptation and disasters from the global fund. At even half this rate, and with participation by just half of producing nations, such bonds would be more than adequate to cover all of the global climate adaptation costs estimated by the World Bank plus two Haiyan-scale disasters per year. So not only is this affordable, but also would generate climate funding at a scale that could provide real relief for those least able to protect themselves from the onslaught of droughts, floods, epic storms and sea level rise.

Climate bonds also have the right incentives. First, companies who post these bonds would be able to recoup them once they are out of the fossil fuel business, the sooner the better because as time goes on climate disaster costs are expected to soar. Secondly, the amount of bonding would be less for companies that seek to limit fossil fuel combustion along the entire life-cycle. While no fossil fuel production is risk free, the cleaner it is along the chain of production (i.e. minimizing methane leakage) the better. Third, climate bonds would provide an up-front signal that the era of public subsidies for fossil fuels have ended. Instead, companies that want to perpetuate our addiction to fossil fuels will have to bear the full costs of doing so. Fourth, nations that are now just entering the fossil fuel production business would think twice about doing so. By choosing not to produce, they would retain eligibility for climate finance and avoid the costly subsidies of new production. Finally, companies that operate in early-adopting countries, states, and provinces would have incentive to promote climate bonds worldwide to reduce their financial liabilities.

In the wake of Typhoon Haiyan, further development of this concept could help break the logjam on climate solutions in a way that remedies grave injustices and speeds the transition to a renewable energy platform for the 21st century economy. Importantly, it provides a pathway for international cooperation by state and local governments at the front lines of extraction and disaster response.